Republican Tax Plan Poses Risk to U.S. Bond Market

Republican plans to scale back tax deductions on corporate interest risk pushing more borrowing overseas, say experts and market participants, eroding the competitive advantage of the mammoth U.S. bond market.

Rep. Kevin Brady (R., Texas), chairman of the House Ways and Means Committee, said this month he wanted to curtail companies' capacity to deduct net interest payments from taxable income to pay for tax cuts. The comments virtually ensure the topic will feature prominently in the coming tax debate, expected to begin in earnest after Labor Day.

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White House officials and top House Republicans say they are optimistic about finishing a major tax bill this year, but they have a long way to go. President Donald Trump is set to cite the importance of a tax-code revamp in a speech Wednesday afternoon in Missouri.

Any U.S. limits on interest write-offs would diverge from the policies in many other rich countries and likely prompt companies to shift some borrowing to places where deductibility would still be in effect, many analysts say. Large U.S.-based companies like Apple Inc. and Microsoft Corp. routinely borrow billions of dollars in the U.S., knowing that interest payments will lower their tax bills.

Ironically, a tax revamp meant to boost U.S. competitiveness and bring overseas earnings home may weaken a central pillar of the U.S. capital markets.

"If you remove interest deductibility in one location and retain it in others, then of course companies will want to move their borrowing," said Matt King, a credit analyst at Citigroup Inc.

A spokesman for the House Ways and Means Committee said that the tax cuts will help revitalize the economy, which in turn will stimulate capital markets.

A postcrisis debt boom has only burnished the U.S.'s status as the world's largest bond market. Companies routinely borrow billions to build new factories, finance acquisitions and fund share buybacks. Nonfinancial, investment-grade companies in the U.S. have borrowed roughly $575 billion so far this year, on pace to break the record of close to $800 billion set in 2015, according to Dealogic.

More than $6 trillion worth of corporate bonds were outstanding in the U.S. as of Aug. 22, according to Dealogic. That is almost triple the figure in the euro corporate debt market, the world's second largest.

The U.S.'s sophisticated market infrastructure and ample liquidity give corporations better access to debt financing than anywhere else. While those advantages make a wholesale shift to other borrowing markets unlikely, changing the tax code could push some borrowing into foreign markets, Mr. King said.

Debt is popular because it is cheaper than selling equity. Its low cost is enhanced by deductibility, which began in the early 1900s when railroad and real-estate executives convinced the federal government their businesses wouldn't survive if they paid interest with after-tax profits, said Steve Bank, a professor at the UCLA School of Law.

Ending or limiting that deduction is key to funding the House tax plan. Repeal would raise $1.5 trillion over a decade to replace some of the revenue lost from a corporate rate cut and immediate deductions of capital expenses, according to the Tax Foundation, a conservative-leaning think tank.

Multinationals have shown they can deftly manage any difference between countries' tax policies to their benefit, said Brian Kittle, a tax lawyer at Mayer Brown LLP. Companies including Mylan NV, Medtronic PLC. and Johnson Controls International PLC, have in recent years moved abroad in part to lower U.S. tax bills.

Removing interest deductibility would create a "strange and ironic" echo of such "corporate inversion" strategies in which firms move their headquarters overseas but keep their main operations in the U.S., said Citigroup's Mr. King. In this case, companies could keep their funds in the U.S. and borrow elsewhere.

U.S. companies have also stockpiled more than $2.6 trillion in earnings offshore, because they don't pay U.S. tax on any reinvested foreign earnings. Companies like Apple, Microsoft and Pfizer Inc. then unlocked those funds by borrowing in the U.S.

Those three companies have collectively borrowed almost $200 billion in the U.S. investment grade bond market since 2008, according to Dealogic, even as their earnings overseas rose.

Foreign firms already borrow in the U.S. to lower their tax bills. German industrial conglomerate Siemens AG has borrowed $21.25 billion in the U.S. investment grade market since 2015.

Others are spreading their bets. Apple issued a 2.5 billion Canadian-dollar bond in August, the largest corporate borrowing by a foreign issuer on record there.

Companies are borrowing more now in anticipation of tax changes later, said Dominic Pappalardo, a portfolio manager at McDonnell Investment Management LLC, which manages $11.5 billion in fixed-income assets.

"The abundance of new supply is very well received," he said. "But if you roll the clock forward, finding new bonds could become challenging."